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SESSION 6: ESTIMATING COST OF
DEBT, DEBT RATIOS AND COST OF
CAPITAL
‹#›
Bringing debt into the capital equation
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What is debt?
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
For an item to be classified as debt, it has to meet three criteria:





It has to give rise to a contractual commitment, that has to be met in good
times or bad.
That commitment usually is tax deductible
Failure to make that commitment can cost you control over the business.
Using these criteria, all interest-bearing commitments, short term
as well as long term, are clearly debt. So, are all lease
commitments.
The items below can be debt, if they meet other conditions


Accounts payable & supplier credit, but only if you are willing to make the
implicit interest expenses (the discounts lost by using the credit) explicit.
Under funded pension and health care obligations, but only if there is a
legal requirement that you cover the underfunding with fixed payments in
future years.
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Estimating the Cost of Debt
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

The cost of debt is the rate at which you can borrow at
currently, It will reflect not only your default risk but also the
level of interest rates in the market.
The two most widely used approaches to estimating cost of
debt are:



Looking up the yield to maturity on a bond issued by the firm. The
limitation of this approach is that few firms have long term straight
bonds that are liquid and widely traded.
Looking up the bond rating for the firm and estimating a default
spread based upon the rating. While this approach is more robust,
different bonds from the same firm can have different ratings. You
have to use a median rating for the firm
When in trouble, either because you have no ratings or
multiple ratings for a firm, estimate a synthetic rating for your
firm and the cost of debt based upon that rating.
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Estimating Synthetic Ratings
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
The rating for a firm can be estimated using the financial
characteristics of the firm. In its simplest form, the rating
can be estimated from the interest coverage ratio
Interest Coverage Ratio = EBIT / Interest Expenses

For Embraer’s interest coverage ratio, we used the
interest expenses from 2003 and the average EBIT from
2001 to 2003. (The aircraft business was badly affected
by 9/11 and its aftermath. In 2002 and 2003, Embraer
reported significant drops in operating income)
Interest Coverage Ratio = 462.1 /129.70 = 3.56
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Interest Coverage Ratios, Ratings and Default
Spreads: 2003 & 2004
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If Interest Coverage Ratio is
Spread(2004)
> 8.50
(>12.50)
6.50 - 8.50
(9.5-12.5)
5.50 - 6.50
(7.5-9.5)
4.25 - 5.50
(6-7.5)
3.00 - 4.25
(4.5-6)
2.50 - 3.00
(4-4.5)
2.25- 2.50
(3.5-4)
2.00 - 2.25
((3-3.5)
1.75 - 2.00
(2.5-3)
1.50 - 1.75
(2-2.5)
1.25 - 1.50
(1.5-2)
0.80 - 1.25
(1.25-1.5)
0.65 - 0.80
(0.8-1.25)
0.20 - 0.65
(0.5-0.8)
< 0.20 (<0.5)
D
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Estimated Bond Rating
AAA
AA
A+
A
A–
BBB
BB+
BB
B+
B
B–
CCC
CC
C
0.75%
1.00%
1.50%
1.80%
2.00%
2.25%
2.75%
3.50%
4.75%
6.50%
8.00%
10.00%
11.50%
12.70%
15.00%
Default Spread(2003) Default
0.35%
0.50%
0.70%
0.85%
1.00%
1.50%
2.00%
2.50%
3.25%
4.00%
6.00%
8.00%
10.00%
12.00%
20.00%.
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Cost of Debt computations
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
The cost of debt for a company is then the sum of the riskfree rate and the default
spread:
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
Pre-tax cost of debt = Risk free rate + Default spread
Companies in countries with low bond ratings and high default risk might bear the
burden of country default risk, especially if they are smaller or have all of their
revenues within the country.
Pre-tax cost of debt = Risk free rate + Company Default Spread + Country Default Spread
Larger companies that derive a significant portion of their revenues in global markets may be
less exposed to country default risk. In other words, they may be able to borrow at a rate
lower than the government.


The synthetic rating for Embraer is A-. Using the 2004 default spread of 1.00%, we
estimate a cost of debt of 9.29% (using a risk free rate of 4.29% and adding in two
thirds of the country default spread of 6.01%):
Cost of debt
= Riskfree rate + 2/3 (Brazil country default spread) + Company default spread =4.29% +
4.00%+ 1.00% = 9.29%
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Weights for the Cost of Capital Computation
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

In computing the cost of capital for a publicly traded
firm, the general rule for computing weights for debt
and equity is that you use market value weights.
That is not because the market is right but because
that is what it would cost you to buy the company in
the market today, even if you think that the price is
wrong.
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Getting a market value for debt: Disney
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
Convert book value of interest-bearing debt to market value, using a
simple bond pricing equation. In 2013, Disney’s total debt due, in book
value terms, on the balance sheet is $14,288 million, the total interest
expense for the year was $349 million and the weighted maturity of its
debt was 3.75%. Using 3.75% as the pre-tax cost of debt:
é
ù
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 Estimated MV of Disney Debt =
ê (1- (1.0375) ú
14, 288
349 ê
ê
êë

7.92
.0375
ú+
= $13, 028 million
7.92
ú (1.0375)
úû
To convert leases into debt, you take the PV of lease commitments in the
Year Commitment Present Value @3.75%
future @3.75%
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$507.00
2
$422.00
3
$342.00
4
$272.00
5
$217.00
6-10
$356.80
Debt value of leases
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$488.67
$392.05
$306.24
$234.76
$180.52
$1,330.69
$2,932.93
Disney reported $1,784 million
in commitments after year 5.
Given that their average
commitment over the first 5
years, we assumed 5 years @
$356.8 million each.
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Estimating Cost of Capital: Embraer in 2004
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
Equity
Cost of Equity = 4.29% + 1.07 (4%) + 0.27 (7.89%) = 10.70%
 Market Value of Equity =11,042 million BR ($ 3,781 million)


Debt
Cost of debt = 4.29% + 4.00% +1.00%= 9.29%
 Market Value of Debt = 2,083 million BR ($713 million)

Cost of Capital
Cost of Capital = 10.70 % (.84) + 9.29% (1- .34) (0.16)) =
9.97%

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If you had to do it….Converting a Dollar Cost of
Capital to a Nominal Real Cost of Capital
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
Approach 1: Use a BR riskfree rate in all of the calculations above.
For instance, if the BR riskfree rate was 12%, the cost of capital
would be computed as follows:
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
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
Cost of Equity = 12% + 1.07(4%) + 27 (7. %) = 18.41%
Cost of Debt = 12% + 1% = 13%
(This assumes the riskfree rate has no country risk premium
embedded in it.)
Approach 2: Use the differential inflation rate to estimate the cost
of capital. For instance, if the inflation rate in BR is 8% and the
inflation rate in the U.S. is 2%
Cost of capital=
é 1+ Inflation ù
BR
(1+ Cost of Capital$ )ê
ú
ë 1+ Inflation$ û
= 1.0997 (1.08/1.02)-1 = 0.1644 or 16.44%
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Dealing with Hybrids and Preferred Stock
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

When dealing with hybrids (convertible bonds, for
instance), break the security down into debt and equity
and allocate the amounts accordingly. Thus, if a firm has
$ 125 million in convertible debt outstanding, break the
$125 million into straight debt and conversion option
components. The conversion option is equity.
When dealing with preferred stock, it is better to keep it
as a separate component. The cost of preferred stock is
the preferred dividend yield. (As a rule of thumb, if the
preferred stock is less than 5% of the outstanding market
value of the firm, lumping it in with debt will make no
significant impact on your valuation).
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Recapping the Cost of Capital
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